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In 2007, the US economy experienced the worst mortgage crisis ever that led to panic and financial challenges all over the world. The primary cause of the mortgage crisis was excessive borrowing and unfeasible financial projection. The projection relied on the assumption that the local prices only increased. Fraud and greed were other factors that intensified the crisis. The mortgage crisis began when subprime borrowers defaulted as a result of change of mortgage interest rates. The risks of the defaulters spread through financial tools to almost every sector of the world economy. The unfolding of the mortgage crisis can best be illustrated through an analysis of the issues that culminated to the crisis.
In the early 2000, there was a global increase in capital. The capital was, in fact, excess forcing all investment managers to seek ways of investing. This created a demand for low risk investments because they fetched high returns. As a result of lack of such investment places, the excess capital was injected into the US mortgage market. People got mortgage loans from brokers who in turn sold them to the banks. The banks then sold the mortgage to top investment companies. The companies were then supposed to sell shares from the returns to other willing investors. This trend was seen as the best strategy to own assets.
The demand for mortgage backed securities (MBS) was rising steadily up to a point in which anyone who applied for a mortgage and qualified got it. Lenders started to give loans without verifying the assets and later without even checking incomes. People only needed to prove that they had loaded bank accounts to get loans. The situation got worse when lenders began to issue loans without verifying bank accounts or assets. The banks did not care about the securities because the Wall Street carried the risk. Agencies underestimated the risk basing their assumption on the previous occasion where there were no defaulters.
The housing market in the US was growing steadily until 2006. At that time, it was easy to access a house-loan which increased demand for houses. The house prices also increased as a consequence of the rising demand. Investors started to buy and sell houses that were in high demand then. The prices kept rising until people could not afford them anymore. Some people started to pay their installments by taking other loans against their houses.
The breaking point
Although the house prices were increasing, the earnings per household were not rising. As a result, they could no longer afford the high prices. As a result of the now decreased demand, the house values dropped abruptly. Many people were unable to pay their mortgages and even defaulted on their first payment. The number of people failing in paying their mortgages increased while increasing the number of houses in the industry. The prices of the houses dropped because there were more houses than the available buyers. In the early 2007, the prices dropped to a point where mortgage companies went out of business. This is because people were no longer interested in purchasing risky mortgages. However, this was too late because large amounts of these securities had accumulated in the market. Large financial institutions, as well as individuals, had already bought these mortgage securities while assuming that they were the same as liquid cash. Investors thus lost a lot of money because the securities were now worth far much lesser than they initially were.
The effects of securitization in the sub-prime mortgage crisis
Securitization also had some influence in the sub-prime crisis. In some occasions, it assisted in the misalignment of interests. Securitization is a financial tool that enables lenders to spread their funding base and reach a wider assortment of investors. Securitization helped the growth of a synthetic market in sub-prime MBS, which had the effect of increasing the blow on defaulters. The independent mortgage broker who sold the mortgage to the identified financing company had little regard to the risk involved. Although the finance firm involved scrutinized the performance of the broker’s loan, the broker carried no risk of the loan irrespective of the performance. The finance firm buying the loans had to device strategies to safe guard the loan and had an interest in the performance of the mortgage loan. However, due to the high demand for the mortgages, the brokers were successful in selling the loans. Since they were able to sell the mortgage loans almost immediately, they had little concern of the risks involved. Their interest was to create several types of loans and in large amounts as the market demanded. This trend fueled the trend which culminated to the Sub-prime mortgage crisis.
Another significant aspect that resulted from securitization was a demand for mezzanines from the collateralized debt obligation (CDO) managers. CDO managers purchased several bonds from the finance firms because the cash buyers were absent or not willing to buy. In addition, the bonds were convenient than cash-buying because the rating agencies projected that portfolio of subsidiary mezzanine bonds from a variety of securitizations would not necessarily be correlated. As a result of the projection of the low correlation, collecting the sub-prime mezzanine bonds into a CDO system allowed the CDO managers to develop new rated CDO bonds. This trend led to an increased demand for sub-prime mezzanines. This contributed to the rise of the sub-prime mortgage crisis.
Reasons why people engaged in the risky lending trends
One of the reasons, why different parties engaged in the risky lending practices is because the lending party close to the house owner had little knowledge of the trend. They were interested in making profits from the sale of mortgages and had little regard to the performance of the loan. The CDO managers too were oblivious of the effects of the trend and their consistent purchase of assets, issuance of liabilities and trades in CDO equity was rewarded by the management. This is because it helped in increasing the assets of their firms. Of course, everyone assumed that the prices of the house would keep on rising and at no point will they lower.
The combination of different financial forces led to the rise of the sub-prime mortgage crisis. The crisis first affected the real estate industry and later spread to the entire economy. The interest only loans had the effect of lowering the monthly installments to levels which the sub-prime borrowers could afford. This consequently raised the lenders risk as the initial rates were re-set. The lenders assumed that the borrowers would rather sell their houses at a higher price instead of defaulting. This was not; however, the case as the financial forces changed the situation lowering the house prices. The mortgage backed securities contributed to the sub-prime mortgage crisis because they allowed the lenders to accumulate loans and sell in wholesale. This created extra funds for the banks to lend. With the mortgage becoming available to everyone who qualified, the high demand for the houses led to rise in prices until the breaking point when people could no longer afford. House price thus lowered ushering the sub-prime mortgage crisis.